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Foreign aid and volatility of natural resource revenues in low-income countries

Anton Dobronogov's picture

An abundance of natural resources is both an opportunity and a challenge for developing countries. A number of resource-rich, low-income countries receive amounts of foreign aid that are similar to or larger than their actual or potential revenues from natural resources. A new policy research working paper by Octave Keutiben and me develops a growth model to look at some ways in which the donors may help governments of such countries to use their resource revenues productively and minimize the magnitude of risks created by resource rents. The paper’s key conclusion is that making aid countercyclical helps to achieve higher economic growth, and so does conditioning disbursements on enhancement of public capital.

Foreign aid may potentially help to stabilize the government revenues, making it easier for a country with limited institutional quality to stabilize expenditures. This will happen if amounts of aid are systematically countercyclical with respect to natural resource revenues (or with respect to its prices if extraction remains relatively stable). Foreign aid can also enhance stock of public capital in many ways which are by no means limited to financing infrastructure projects. Investments in human capital through public spending on social services such as primary health care and primary education may have positive externalities in the developing countries, benefiting not only direct recipients of these services. Hence, a portion of human capital produced by such investments can be thought of as public capital. Further, aid may enhance public capital not only by financing specific investments, but also by means of supporting policy reforms and institutional changes which make public spending on infrastructure and social services more effective, such as, for example, strengthening fiscal rules and improvements in the budgeting process or in public financial management.

One way then to ensure that foreign aid is both countercyclical and helps to enhance the stock of public capital is to introduce elements of insurance in the design of foreign aid programs and products financing investments in infrastructure and social services and supporting policy and institutional reforms. In his recent post on this blog, Alan Gelb discusses another paper which suggests some ways in which a donor like International Development Association may put this in practice.